'Outlier' S&P may upgrade Indonesia, triggering fund flows

Progress on fiscal reforms may prompt S&P to return Indonesia's credit rating to investment grade this year — a vote of confidence expected to trigger capital inflows to Southeast Asia's largest economy, economists and fund managers told CNBC.

S&P remains the only major ratings agency to classify Indonesia's sovereign debt one notch below investment grade, also known as "junk." Rivals Fitch and Moody's both rate Indonesia as investment grade and recently revised the outlook to positive from stable.

Finance Minister Sri Mulyani Indrawati, in an interview with CNBC last September, hinted that a rating upgrade may be in the cards although she didn't specify the agency she thought could take action.

Indonesia failed to win an S&P upgrade last year because of rising non-performing loans. Kyran Curry, the agency's primary analyst for the country, affirmed Indonesia's BB+ rating in June with a positive outlook. When contacted by CNBC, an S&P spokeswoman said the agency wasn't planning any immediate ratings changes beyond its latest research update published in June.

"S&P is the outlier, and I would think they would be seriously contemplating their rating," said Smriti Shekhar, portfolio manager with NN Investment Partners' equity markets group.

"There is decent depth in the market and the basic economy is on a strong footing today vis-à-vis its foreign exchange balances. There is a reasonable degree of implicit confidence in that structure now versus 15 years ago."

Markets have applauded Indonesian President Joko Widodo's signature tax amnesty program and infrastructure spending pledges, which have helped offset some of the damage done by the commodities collapse and the post-U.S. election jump in the U.S. dollar and treasury yields.

"We expect S&P to upgrade Indonesia's rating to investment grade sometime in the near term," said Neeraj Seth, head of Asian credit at BlackRock, which oversees $5.1 trillion. "Indonesia has a strong track record of fiscal discipline and the government has demonstrated a strong commitment towards reforms through fuel subsidy rationalization and multiple policy packages since September 2015."

Investment professionals contacted by CNBC were divided over the net market impact of an S&P upgrade, but they all said they believed a re-rating was warranted.

Luke Spajic, the head of emerging Asia portfolio management at Pimco, which oversees about $1.55 trillion, said capital inflows are expected to be modest in the event of an S&P upgrade since the move is widely anticipated and largely priced into asset valuations. Near-term, Spajic recommend "some reduction of risk" given fears of a commodity-led correction gathering momentum.

"One could argue that the steep recovery in commodity prices has helped significantly, so a sharp retracement would send valuations back," Spajic told CNBC via e-mail. Indonesia, however, "has been a large overweight in our Asian dedicated portfolios," he said.

OCBC economist Wellian Wiranto said "a full-suite investment grade should open up new areas of demand." Japanese investors could "form a new pipeline for demand, once there is no more cross-over rating," he said.

But Rohit Garg, emerging Asia fixed income and currency strategist at Bank of America Merrill Lynch, said he didn't expect S&P to upgrade Indonesia this year because of the rise in non-performing loans — S&P's primary source of concern — has not been contained.

Based on data from Indonesia's central bank, Bank Indonesia (BI), the country's NPL ratio reached 3.1 percent in January 2017 — up from 2.93 percent in December 2016 and 2.49 percent in December 2015.

"Even though BI has mentioned that NPLs have peaked, S&P may not upgrade Indonesia this year," Garg said in a March 6 report.